E&Y Study: Small Caps Ripe for Picking

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A decline in market capitalization among companies listed in the Russell 2000 Index of small-cap companies is driving strong mergers and acquisitions activity, according to an Ernst & Young analysis of the index’s annual reconstitution.

A total of 137 companies were removed from the index because they were acquired, E&Y noted. Thirty-three of them were in the financial sector, followed by healthcare (25 companies), information technology (21), industrials (18), and consumer discretionary (14).

While there’s been a marked falloff in mega-deals, mid-size deals of $1 billion or less have been very prevalent, said Maria Pinelli, Americas director of strategic growth markets for E&Y.

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The trend of cash-rich companies picking off promising small caps seems likely to continue. “With a significant reduction in overall Russell 2000 market capitalization over the past year, good companies that were valued at a premium just a few years ago may well be valued at a discount in the current market environment,” said Pinelli. “Such undervalued companies could become candidates for M&A, particularly for well-capitalized suitors who don’t need extensive debt in order to fund strategic transactions.”

In the reconstituted index, the threshold for entry fell from $262 million in 2007 to $167 million this year, while the median market cap declined from $705 million to $520 million.

The smaller companies that are now included in the index benefit from the increased liquidity and the exposure gained from the vast institutional investor universe that adheres to index strategies, according to Pinelli. The increased exposure does create added pressures for the companies but also adds potential for capitalization. “Being in a major index could enhance their ability to execute their growth strategies and achieve continued success,” she said.

Market caps for companies in the Russell 2000 now range from $36 million to $3.6 billion, with an average of about $1.1 billion and a median of $485 million.

E&Y noted that 38 of the issues that were added to the index dropped down from the Russell 1000 Index of large-cap companies, while 26 came from the over-the-counter market.

In addition, 93 came from IPOs. Among these, 62 percent have global operations and six companies have their primary location in countries other than the United States.

E&Y said the reasons for the additions from the OTC market range from companies simply boosting their performance to international companies seeking an entry point into the U.S. market.

Among companies that were deleted, in addition to the 137 that were acquired, 45 moved up to the Russell 1000, three were delisted, four entered Chapter 11 protection, and five were taken private.